Corporate crime

Lead bosses not into temptation

How to make shares less of an inducement to corporate crime

“REMAINING CEOs make a break for it: band of roving chief executives spotted miles from Mexican border,” joked a satirical website in 2002, as reports of corporate scandals reached fever pitch. Slowly but surely, the alleged outlaws have been rounded up. New York's courts this week saw a new trial begin, of members of the Rigas family which ran Adelphia. The trials of Martha Stewart, the life-style guru, and of Dennis Kozlowski, former boss of Tyco, continue. This month Jeffrey Skilling (right), erstwhile chief executive of Enron, was indicted for fraud and insider trading. Kenneth Lay, Enron's former chairman, remains under investigation.

Full marks, then, for prosecutorial effort—though it remains to be seen who actually goes to jail (see article). And yet even if successful, a few criminal trials can never themselves take the place of thorough reforms aimed at reducing the ability of bosses to misbehave. Following the hastily passed Sarbanes-Oxley act of 2002, much remains to be done, especially regarding a factor common to many recent scandals: the pernicious relationship between a boss and his firm's shares.

During the 1990s, American bosses were given vast amounts of shares and share options by their companies. In theory, this should have encouraged them to run their firm to maximise its value, to the benefit of all its shareholders. In practice, many bosses instead pursued a “pump and dump” operation: doing all they could to push up the share price, including using dodgy accounting, only to sell their shares at the top of the market before the truth emerged. Mr Skilling is accused, among other things, of making at least $66m by fraudulently boosting Enron's share price.

If Mr Skilling is convicted, that should deter others. Yet strikingly little else has been done to reduce the temptation for executives to trade their firms' shares in ways that harm other shareholders. True, there has been a modest reduction in the use of share options, an especially effective incentive to pump shares because options are worth a fortune if the share price rises above the exercise price, but nothing if it does not. Instead of options, firms now favour outright grants of shares—albeit restricted, so that the shares must be held for a period before their sale. This reduces the incentive for pumping, but certainly does not eliminate it.

One elegant solution would be to restrict executives from selling shares in their firm until long enough after they had retired for any misbehaviour during their tenure to come to light. But objections from executives that they want to use some of their wealth while they are still young enough to enjoy it should be weighed in the balance, and this makes a complete ban on share sales until after retirement seem extreme.

Tell before you trade

So if executives are to be allowed to sell (or, indeed, buy) their own company's shares while they are still working at a firm—and thus while they are better informed about its operations and prospects than any other investors—tougher rules are needed to protect fellow shareholders. Existing insider-trading laws are clearly inadequate, not least because the authorities lack the funds to pursue all but the most egregious cases. And making such laws effective may be harder than simply making it easier for market forces to keep bosses in check.

A simple and attractive way to bring market forces into play would be to require executives to pre-announce, by perhaps a week, their intention to trade. Executives would then be obliged to go through with the trade. This would give outside shareholders a chance to decide whether the trade was due to something a boss knew exclusively—in which case, the share price could rise or fall as appropriate, stopping the boss from profiting from that knowledge. Currently, trades must be revealed two days after they take place—an improvement on the up-to-six-weeks-later rule that was in place until recently, but still too late for investors to stop the boss cashing in.

This new rule would probably not prevent a huge, planned long-term fraud of the sort alleged to have been perpetrated by Mr Skilling. But creating conditions in which the buying or selling of shares by bosses is properly scrutinised by the market before a transaction happens would make it much more likely that the equity carrot promotes good behaviour by bosses, as it was supposed to do, not bad.